There are multiple methods for raising funds to provide liquidity for a firm. Some of the options that the firm can utilize to raise the funds are bank loan, issue of bond and issue of equity. An organization operates its business and engages in a variety of activities. These activities might be connected to the movement of items, the inflow and outflow of funds inside the company, and so on. What matters is that all business-related actions are linked by a monetary resource. It signifies that a corporation needs money to carry out its activities. The benefits and costs of all the mentioned sources of financing along with the cost of capital and average time frame are discussed below:
A bank loan is a sort of debt financing in which a corporation can borrow money from the bank for a medium and long period of time. Various organizations give bank loans to businesses at cheap interest rates, which is advantageous for businesses looking to obtain more cash at lower rates. Banks also have their own set of restrictions and rigorous qualifying requirements that businesses must follow before asking for a loan. Companies like to work with well-established banks that can help them secure a loan. Bank loan is the conventional method of acquiring funds; when no other financial firms are available, enterprises turn to banks for help. The cost of capital for bank loan may be fixed or floating and the benefits of the cost of capital may be observed on a comparative basis. Bank loan may be short-term or long-term with cost of capital being different for all types of loans.
The availability of debt depends upon the stage the company is operating currently as lenders will be hesitant to invest in a new firm that has yet to establish itself in the market, and they will be hesitant to risk their money with them.
There may be instances where the corporation pays a high price since various banks charge varying interest rates, which can be costly when it comes time to repay. As a result, you must make your decision based on your budget.
The firm can also issue equity shares of the company to the general public investors, both individual and institutional for the purpose of raising funds (Tykvová 2018). The company generally sells the shares in the market through the process of Initial Public Offering (IPO). The initial public offering (IPO) is a way for well-established enterprises to raise capital. An IPO allows a firm to sell its stock to the general public as well as a large number of investment firms (Hartana 2019). It is more expensive than other options and takes a lot of time and work. The time frame for such capital is not fixed and company can invest into longer term projects using this capital. As a firm grows from a start-up to a well-established company, it passes through numerous rounds of equity funding. Meanwhile, the firm is in many economic stages, each with its own set of financial requirements. As a result, different sorts of sources are appropriate for different situations. The advantages and disadvantages of equity financing are as follows:
The capital that is raised using the equity method of financing does not required to be repaid back like in the case of debt financing. The company may look for projects with longer term if profitable, to invest the capital into (Coleman, Cotei and Farhat 2016). The company is not required to let go off a portion of the profit for servicing the equity capital just as in the case of debt financing.
The company has to let go off a portion of the company’s shares in return for capital collected by the investors purchasing the shares of the company.
The financial instrument that a company offers at face value is known as a bond issued at par. At the time of the bond's maturity, the bondholder will receive the face value or par value of the bond (Cole and Sokolyk 2018). The bonds can be sold at par, at a discount, or at a premium. Its issuance is contingent on interest rate or coupon rate variations in the market. When the coupon rate is lower than the yield to maturity, the bonds are said to be issued at a discount. If the coupon rate is higher than the interest rates, the bonds were sold at a discount whereas the bond is expected to be sold at a premium if the coupon rate is higher than the interest rate.
There are different types of bonds which a corporation can issue to raise capital and they involved zero-coupon bonds, convertible bonds and normal corporate bonds.
Issuing bonds gives the company a flexibility in terms of the type of bonds that it can issue and the timeframe of the bonds in which it will be due for redemption. Also, the coupon paid against the bonds are tax deductible for the company (Alzoubi 2018).
During times of economic prosperity, debt financing is readily available because lenders are less concerned about default. Obtaining debt finance during economic downturns, when businesses require the greatest money, is more difficult (La Rosa et al 2018).
The investors looking for investment of capital into stocks may want to calculate the intrinsic value of the stock to assess the fair value of the stock. For this purpose, there are multiple valuation techniques which the investor can utilize. The following section highlights the different types of stock valuation methods and their characteristics:
The model assumes that the intrinsic value of a stock depends upon the expected dividend of the company. The discounted sum of all the dividend payments that the company is going to make in future using an appropriate cost of equity would represent the intrinsic value of the stock (Sim and Wright 2017). The terminal value in this method is calculated by dividing the end of period dividend with cost of equity deducted by growth rate to account for the perpetual feature of the company. However, the assumptions of the model which include regular and fixed amount of dividend with a stable payout ratio over the future years, is considered as irrationals. The model may suggest faulty intrinsic value if the forecast of the dividend is not accurate. Also, the model cannot be used to value companies which are planning to grow internally having a 0-payout ratio.
The adjusted dividend discount model is a modification of the traditional dividend discount model. The difference between the methods is that the adjusted DDM uses the price/earnings method to estimate they should be current price of the stock and that price needs to be treated as the terminal value for going concern in the adjusted DDM method (Lazzati and Menichini 2015).
This method of valuing the stock of a company is relatively simple compared to other stock valuation technique. The method involves estimating the average P/E ratio of all the comparable companies listed on the market and multiplying the estimated earnings of the company with the average P/E ratio. The model assumes that the future earnings plays an important role in predicting the value of a stock. The model assumes that the growth in earnings in future periods would be similar to the average industry earnings growth. If the estimated earnings of the company are incorrect, the model may result in faulty valuations of the company. Also, the price to earnings ratio is volatile in nature and investors do not have much confidence over the p/e ratio metric.
The FCF model is appropriate for companies which do not pay dividends and have a positive stream of cash flows. The companies having negative profit in the income statement can also use this method for valuation if they have positive cash flows. The FCF model is based on the assumption that the value of a company’s stock is based on the discounted value of the future free cash flows of the company using an appropriate weighted average cost of capital (Buus 2015) The model can be termed as the best of all methods as it incorporates various details and data. The method is detailed and well crafted which in turn makes the model prone to sensitivity to multiple inputs. The various components of the FCF model involves calculations of the free cash flow of the company using data published in the financial statements of the company. It is important to estimate a weighted average cost of capital which includes the components of equity and debt into the calculations. The cost of equity of the company may be calculated using the CAPM method or the dividend growth model. The cost of debt may be calculated using financial data like interest expense of the company and the total proportion of interest-bearing long-term debt. Another method of estimating cost of debt can be attributed to the yield on bonds issued by the company or its competitors which can act like comparable companies. The book value or the market value of the equity and debt in the company is used as the weight for multiplying the respective cost of capital sources.
In order to value the stock of Tesla, the most suitable method is the FCF model as the company has stopped paying dividends after the 2020 Covid 19 pandemic. The FCF model would help to estimate the future expected free cash flows of the company based on an appropriate growth rate and discount the cash flows using Weighted Average Cost of Capital of the company. The stock of Tesla can also be valued using the price to earnings method which would assign an intrinsic value to the company based on the PE multiple of the comparable companies. But the comparable companies which aptly present the financial and operational similarity with Tesla, hence the FCF model is the perfect method to value the stock.
Dividend Discount Model
Generally, it is estimated that an investor would prefer to invest into countries where the interest rates are higher as opposed to countries where the interest rates are comparatively lower. But it has been observed that the investors hesitate from investing into countries with higher interest rates like in the case of Germany. The reason behind this may be traced back to the economic model of interest rate parity, where the model states that the absolute return in case of high interest rate countries would be similar with the low interest rate countries due to the effect of exchange rates. A country with a high interest is expected to experience a depreciated currency rate compared to the currency of the investor’s country. The inflation differential would result in similar level of profits according to the theory of Interest Rate Parity. The forward rate differs from the spot rate by an amount adequate to counteract the interest rate disparity between two currencies due to market factors. If the theory holds good the investors believe that the cost involved in investing into foreign country with high interest rate would outweigh the amount of the profits earned from the investments.
Countries may also be involved in artificially inflating the interest rate in the economy to attract foreign capital and build up foreign exchange reserves. But this strategy runs the risk of the country being financially weak as higher interest rate environment decreases the level of expenditure in the economy. Business and households would be discouraged to borrow and spend and on the other hand they would be encouraged to save more money due to the higher interest on offer. Due to the fear of economic and financial instability in countries like these, the foreign investors are hesitant to invest capital into it.
High interest rate environment also gives an indication that the economy of the country is booming and needs to be cooled down. As a result of increase in interest rate, the country would be expecting recessionary economic environment according to the business cycle theories.
Alzoubi, E.S.S., 2018. Audit quality, debt financing, and earnings management: Evidence from Jordan. Journal of International Accounting, Auditing and Taxation, 30, pp.69-84.
Buus, T., 2015. A general free cash flow theory of capital structure. Journal of Business Economics and Management, 16(3), pp.675-695.
Cole, R.A. and Sokolyk, T., 2018. Debt financing, survival, and growth of start-up firms. Journal of Corporate Finance, 50, pp.609-625.
Coleman, S., Cotei, C. and Farhat, J., 2016. The debt-equity financing decisions of US startup firms. Journal of Economics and Finance, 40(1), pp.105-126.
Hartana, H., 2019. Initial Public Offering (Ipo) Of Capital Market And Capital Market Companies In Indonesia. Ganesha Law Review, 1(1), pp.41-54.
La Rosa, F., Liberatore, G., Mazzi, F. and Terzani, S., 2018. The impact of corporate social performance on the cost of debt and access to debt financing for listed European non-financial firms. European Management Journal, 36(4), pp.519-529.
Lazzati, N. and Menichini, A.A., 2015. A dynamic approach to the dividend discount model. Review of Pacific Basin Financial Markets and Policies, 18(03), p.1550018.
Sim, T. and Wright, R.H., 2017. Stock valuation using the dividend discount model: An internal rate of return approach. In Growing Presence of Real Options in Global Financial Markets. Emerald Publishing Limited.
Tykvová, T., 2018. Venture capital and private equity financing: an overview of recent literature and an agenda for future research. Journal of Business Economics, 88(3), pp.325-362.
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